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Brazilian Corporate Governance: Are New Rules Enough?

As regional default risk ticks higher, investors are looking much more closely at how companies are run. New Brazilian governance rules are welcomed, but will they prove toothless?

Brazils financial market regulator is set to tighten up standards of disclosure, tackling controversial areas such as transparency in remuneration and cross shareholdings. The period for public comment on proposed measures ended in April and publication of the new framework should take place early in the second half, although no specific date has been set.

While welcome, investors say that it is partly irrelevant. Despite ever-stronger legislation, companies continue to circumvent the spirit of corporate governance while respecting only the letter of the law.

The aim of the Comissão de Valores Mobiliários (CVM) is to provide investors with a wider range of information. They will include details on total remuneration of individual managers, more on business plans and results, and identification of possible conflicts of interest in cases involving cross-holdings, says commissioner Marcos Pinto. The idea of both the information and voting measures is to encourage investors to monitor activities of controlling shareholders more closely and promote activism, he adds.

There will be three levels of disclosure, depending on outstanding securities, Pinto notes. The first will apply to all companies with equity listed on the BM&F Bovespa; the second to companies that have instruments trading over-the-counter; and the third for entities that have issued debt.

The most controversial aspect is detailed breakdown of remuneration, which applies only to listed entities. Companies say a breakdown is unnecessary, and claim total wage bills should be sufficient, admits Pinto. Many investors insist that this information is critical for them to judge management.

Regarding cross-holdings, many companies have controlling shareholders with stakes in other enterprises. It is very important to identify relevant transactions to mitigate conflicts of interest, says Pinto.

Separately, the CVM has made proxy voting at companies general meetings a reality. New rules compel management to allow investors to vote via the Internet. Until recently, investors had to attend meetings personally to vote. The wide geographic distribution of Brazilian companies effectively curtailed investor participation, Pinto says.

The new standards will bring Brazil more in line with the US and are praiseworthy, notes Claudio Andrade, a founder of Rio-based fund manager Polo Capital. They build on already high standards in Brazil versus other LatAm markets like Chile and Mexico.

Although disclosure standards are theoretically high, companies continue to under-report or hide information because penalties for non-compliance in Brazil are light, Andrade says. Is it improving? Yes, but its still very imperfect, he says.

FX Explosions
Corporate governance was put in the spotlight last year by two scandals concerning forward currency contracts, involving meatpacker Sadia and paper and pulp firm Aracruz Celulose. Sadia shareholders announced in April that they would sue Adriano Lima Ferreira, former CFO, who they accuse of having a role in a 760 million reais loss. Shareholders in Aracruz, which settled a $2.13 billion derivatives loss with banks in a deal that stretches repayment out to nine years, voted in November to sue former CFO Isac Zagury.

Sandra Guerra, founder of Better Governance in São Paulo, which monitors and pushes for better standards, says investors may well have a strong case and the buck may not stop with CFOs. Boards blamed CFOs, but it would be surprising if they themselves did not know their own exposure, she remarks. This is part of a CEOs responsibility. You really cant manage a company without knowing this, says Guerra.

Brazilian law requires the board and officers of the company to exercise the utmost care. We will judge them by these standards, says Pinto. Two CVM investigations, which may result in enforcement procedures, are underway. They will focus on whether boards were diligent in controlling risk and whether they were as informed as they should have been. Penalties range from fines to a ban on managing a company for up to 10 years.

A second area of contention has been incorporation of subsidiary companies into parents, says Andrade. Owners can cut the cake as they will to the detriment of minority shareholders, he notes.

Andrade points to last years absorption of Novo Mercado-listed Tenda, a low-income house builder, into Gafisa through its subsidiary Fit Residencial, a case that aroused the ire of foreign managers. F&C, a London-based fund with over $200 billion under management, and 14 other foreign managers sent a letter to the BM&F Bovespa, complaining that: It appears that [the Gafisa-Tenda deal] is being deliberately structured so as to circumvent Brazilian law, Bovespa listing standards and the rights of minority shareholders.

The UK fund manager went on to complain that the merger, which involved a large issuance of Tenda shares to Gafisa was a move by the latter to take control over a severely diluted Tenda in what was in effect an indirect takeover. The deal nonetheless went ahead.

Fair treatment of minority shareholders in mergers is a grey area. While theoretically, investors can seek arbitration through the CVM, this route is untested, notes Andrade. Investors are reluctant to enter into arbitration because the legal system is slow and uncertain, and companies exploit this, he says.

Last year, merging a parent and subsidiary was identified as a type of transaction that could harm minority shareholders, admits Pinto. The CVM recommends managers of subsidiaries ensure fair treatment in such cases. This voluntary mechanism has led firms to set up a special committee of board members to analyze and approve transactions, as in Votorantim Celulose & Papels proposed take-over of Aracruz Celulose.

There is a significant onus on fund managers to become more actively engaged. Pinto argues that many local hedge funds participate in shareholder meetings and says such investors are interested in the CVMs new disclosure package. Foreign funds also act as a catalyst and as they return to Brazil once the crisis eases, they will help push the governance agenda, he believes.

The recession might also boost involvement, thinks Guerra. Through the 2005-2007 bull market, investors thought they had completed due diligence by confirming a company was Novo Mercado-listed. Now, they are starting to be more discerning. They will increasingly monitor decisions by individual board members and elect members only when they have sufficient knowledge of their background and voting patterns, she predicts. That could help promote more dialogue between boards and investors.

Investors Team Up
There are also more coordinated actions between managers, Guerra says. There are deepening ties between UK pension fund Hermes and Brazils Previ, which has put out a guide for companies on how to conduct AGMs. When you get big funds like this working together, its pretty powerful, Guerra says.

Andrade is more skeptical about the power of managers and their ability to coordinate effectively to prevent corporate governance shenanigans. While fund managers do coordinate on an opportunistic basis to pressure companies, they inevitably remain aware that they are rivals. I dont think that activism is growing substantially. The majority of investors still cut and run by selling down positions when they see problems, notes Andrade.

In spite of this, there have been some successes. A group of four Brazilian fund managers together forced an extraordinary general meeting on Telemig, a mobile phone company 100% owned by Telefonica and Portugal Telecom. Managers called on the firm to distribute much of its free net cash, says Marcelo Mollica, senior analyst at fund manager GAP.

The firm initially declined to meet investor demands, but later approved a dividend of 300 million reais of free cash, meeting some 50% of investor demands. And Telemig is not the only Brazilian entity returning cash to investors, says Mollica. The number of Brazilian companies pursuing equity buyback programs increased substantially in the second half of last year, he notes.

The evolution of corporate governance is a catalyst for Brazilian market development and many listed companies say they understand the importance of codes of conduct. Increasingly, Brazil is seen as a model for other LatAm countries. But until the legal process is improved, companies will continue to undermine the spirit of the law and minority shareholders must heed the dictum caveat emptor.